1. Capital Budgeting Decision-making Criteria
Payback Period
Discounted Payback
Net Present Value (NPV)
Internal Rate of Return (IRR)
Modified Internal Rate of Return (MIRR)

2. Capital Budgeting: the process of planning for purchases of long-term assets
Example:
Suppose our firm must decide whether to purchase a new plastic molding machine for $125,000. How do we decide?
Will the machine be profitable?
Will our firm earn a high rate of return on the investment?

3. Decision-making Criteria in Capital Budgeting
The Ideal Evaluation Method should:
Include all cash flows that occur during the life of the project
Consider the time value of money
Incorporate the required rate of return on the project

4. Payback Period
How long will it take for the project to generate enough cash to pay for itself? 1 2 3 4 5 8 6 7
(500)

5. It takes more than 3, but less than 4 years
Payback Period (PB)
Cumulative
Years
Cash Flow
Cash Flow
-500 1
150
150 2
150
300 3
150
450 4
150
600 5
150
750 6
150
900 7
150
1050 8
150
1200
It takes more than 3, but less than 4 years

6. Payback Period (Continued)
To find the fraction of the 4th year, we first assume that cash flows are evenly distributed throughout the year
Payback = Number of Full Years + [(Initial Investment – Cumulative Cash Flow at the end of Last Full Year) / The Next Year’s Cash Flow]
Payback = 3 + (500 – 450) / 150 = 3.33 years

7. Payback Period (Continued)
Is a 3.33 year payback period good?
Is it acceptable?
Firms that use this method will compare the payback calculation to some standard set by the firm
If our senior management had set a cut-off of 5 years for projects like ours, what would be our decision?
Accept the project

8. Drawbacks of Payback Period
Firm cutoffs are subjective
Does not consider time value of money
Does not consider any required rate of return
Does not consider all of the project’s cash flows

9. Drawbacks of Payback Period (Continued)
Does not consider all of the project’s cash flows.
This project is clearly unprofitable, but we would accept it based on a 4-year payback criterion! 1 2 3 4 5 8 6 7
(500) (300)

10. Discounted Payback (DPB)
Discounts the cash flows at the firm’s required rate of return
Payback period is calculated using these discounted net cash flows
Problems:
Cutoffs are still subjective
Still does not examine all cash flows

11. Discounted Payback – Example1 2 3 4 5
(500)
Cumulative
Year Cash Flow PVCIF (14%) PVCIF
Payback = 2 + [(500 – ) / ] = 2.52 years

12. Net Present Value (NPV) Profitability Index (PI)
Other Methods
Net Present Value (NPV)
Profitability Index (PI)
Internal Rate of Return (IRR)
Each of these decision-making criteria:
Examines all net cash flows
Considers the time value of money
Considers the required rate of return

13. Net Present Value (NPV)
NPV = the total PV of the annual net cash flows – the initial outlay.
Where, FCF is the Free Cash Flow
k is the required return
t is the time subscript
Decision Rule:
If NPV is positive, accept
If NPV is negative, reject

14. Profitability Index (PI)
Decision Rule:
If PI is greater than or equal to 1, accept
If PI is less than 1, reject

15. Internal Rate of Return (IRR)
IRR: the return on the firm’s invested capital. IRR is simply the rate of return that the firm earns on its capital budgeting projects
IRR is the rate of return that makes the PV of the cash flows equal to the initial outlay or NPV = 0
This looks very similar to our Yield to Maturity formula for bonds. In fact, YTM is the IRR of a bond

16. Internal Rate of Return (IRR) (Continued)
Decision Rule:
If IRR is greater than or equal to the required rate of return, accept
If IRR is less than the required rate of return, reject

17. Internal Rate of Return (IRR) (Continued)
IRR is a good decision-making tool as long as cash flows are conventional. ( )
Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. ( )
(500) (200)

18. Internal Rate of Return (IRR) (Continued)
We know that the IRR is the discount rate that makes the PV of the projected cash flows equal to the initial outlay or NPV = 0
Above table shows a trial and error procedure is applied to determine the IRR. Using different discount rates we check if NPV = 0

19. Internal Rate of Return (IRR) (Continued)

20. Modified Internal Rate of Return (MIRR)
IRR assumes that all cash flows are reinvested at the IRR
MIRR provides a rate of return measure that assumes cash flows are reinvested at the required rate of return

21. Modified Internal Rate of Return (MIRR)
Calculate the PV of the cash outflows (PVCOF) using the required rate of return – this is usually the investment amount
Calculate the FV of the cash inflows (FVCIF) at the last year of the project’s time line. This is also called the terminal value (TV)
Using the required rate of return
MIRR is the growth rate of money from initial investment to terminal value over the life of the investment N
I/Y
P/Y PV
PMT FV
MODE
Project Life
MIRR 1
-Investment (PVCOF)
Terminal Value (FVCIF)

22. Modified Internal Rate of Return (MIRR) (Continued)
Finding FV of Uneven Cash Flows:
Cumulate CF one year at a time taking FV into account
Find FV of each CF at the end of project life and then sum FVs
Use of NPV function (faster): First, find the PVCIF (NPV) (exclude initial investment) using required return. Second, change the sign of NPV and store it in PV (now a single cash flow as PV of all cash inflows) to find FV at the end of project life